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From Markit:

“It was a cycle fuelled, in significant measure, not by virtue but by delusion”. The great and the good of the UK economics establishment summed up the housing-fuelled boom of recent times in a letter responding to a request from the Queen. Like many others, she asked “why had nobody noticed the credit crunch was on its way”. Some did, of course, but the “psychology of herding”, as the economists put it, prevented a concerted opposition from gaining

Psychology is finding itself in greater demand as a result of the economic downturn. The efficient market hypothesis is looking more untenable by the day, and economists are looking to other social sciences for insight. The concept of “confirmation bias” is perhaps one of the more relevant to the economic sphere. It is defined as “a tendency to search for or interpret new information in a way that confirms one’s preconceptions and to irrationally avoid information and interpretations which contradict prior beliefs”. Banks, investors and governments may all have been guilty of this flaw in recent years.

Are they still guilty? President Obama declared confidently yesterday that “we have stepped away from a precipice” and the US economy was set to return to growth in the second-half of this year. In this case, the evidence appears to support his view. Second-quarter US GDP figures released today showed the economy contracting by 1%, a sharp improvement from the revised 6.4% contraction in the first-quarter. The US housing market, the cancer at the heart of
the global recession, is also showing signs of stabilisation. New home sales for June were up significantly, and house prices posted their first month-on-month rise since the bubble burst in August 2006.

The credit and equity markets have certainly bought into the scenario of an imminent recovery. Spreads have rallied to pre-Lehman levels, while the major stock indices are at record highs for the year. While economic data has played its part, the real catalyst has been corporate profitability. The number of companies beating earnings expectations has easily outnumbered those that have disappointed, according to Morgan Stanley. Goldman Sachs kicked of the trend earlier this month, and most of the other major banks followed suit. But the trend was not confined to the financial sector. Telecoms, retailers, tech firms – in fact every sector had firms that posted positive earnings surprises.

Are we then returning to the days of optimism? On the face of it, there is reasonable cause for optimism. But those of a bearish disposition also have plenty of ammunition. Take today’s growth figures. The slowing in the rate of contraction was driven by increased government spending, with support from lower imports and smaller declines in business investment.  Personal consumption, the bedrock of the US economy, fell by a higher than expected 1.2%.

What about earnings? What about them, the critics might say. Expectations were low after the awful first-quarter, and it wouldn’t take a stunning performance to beat them. Few firms improved on the same quarter last year. Most of the positive surprises were generated by rigorous cost-cutting rather than higher revenues.

As it stands, the balance between risk aversion and risk appetite is tipped firmly in the favour of the latter. But companies have been less than bullish about the remainder of the year, and the consensus among economists is pointing towards anaemic growth. After the earnings season abates, focus will return to the economy, and next week’s US jobs report has the potential to change the conventional wisdom.